Understanding IFRS 16 is crucial for businesses and financial reporting as it brings significant changes to lease accounting by affecting financial statements. This standard promotes transparency to financial statements by requiring the recognition of lease assets and liabilities, directly impacting financial reporting, lease accounting, and IFRS 16 leases. Here are ten critical points that provide deep insights:
- IFRS 16 Lease definition: enhancing clarity across affected agreements
- Lessee accounting: from dual model to single model approach
- Lessor accounting follows established principles with adjustments
- Right of use asset recognition & subsequent measurement
- Lease liability initial & subsequent measurement
- Expanded presentation & disclosure requirements
- Subleases and sale and leaseback transactions
- Remeasurement of lease liabilities
- Short-term & Low-value assets
- Impact on financial ratios & statements
Our IFRS 16 Summary: 10 Important points you need to know
This post will explore the core facets of IFRS 16, highlighting key aspects of the standard, from the IFRS 16 Lease definition to the impact on financial ratios & statements, we’ll cover the essential points businesses need to understand.
1. IFRS 16 Lease definition: enhancing clarity across affected agreements
IFRS 16 defines a lease as a contract that gives the right to control the use of an asset for a period of time in exchange for consideration. This relies on the lessee’s ability to obtain all of the benefits from the use of the asset throughout the lease and also how and for what purpose the asset is used.
Comparing IAS 17, IFRS 16 has more strict criteria for control. IAS 17 classified leases based on transfer of risk and rewards. Now, under IFRS 16, control is being assessed by whether the lessee has both the right to enjoy nearly all economic benefits from the asset and can decide on its use. This shift is necessary as it creates recognition of leases on balance sheets, aiming to provide a clearer picture of a company’s financial obligations.
For a more detailed guidance, see “does IFRS 16 apply to my contact?”
2. IFRS 16 Lessee accounting: from dual model to single model approach
Under IAS 17, lessees operated under a dual model, this means leases were classified as either operating or finance leases. This classification determined whether lease obligations appeared on the statement of financial position or only in the disclosure notes. Now under IFRS 16, which introduced a single lessee accounting model, requires most leases to be recognised on the balance sheet, capturing a financial liability and a corresponding right of use asset.
Lessee accounts are now simplified by eliminating the need to assess whether a lease is operating or finance but increases transparency by bringing off balance sheet financing into view. This means only the lessee recognises all leases in a similar way, impacting how financial ratios are calculated and potentially affecting business decisions like lease versus buy evaluations and debt covenants. Compared to major changes on the lessee’s side, the lessor accounting remains relatively unchanged, keeping the distinction between operating and finance leases. For a deeper dive into these changes, see our IFRS 16 guide (finance leases for lessees and operating leases)
3. IFRS 16 Lessor accounting follows established principles with adjustments
While IFRS 16 changes the lessee accounting, the lessor accounting remains mostly consistent with IAS 17. Lessors continue to classify leases into finance or operating leases, based on the transfer of risk and rewards incidental to ownership. A lease is classified as a finance lease if it transfers substantially all such risks and rewards to the lessee, otherwise it is an operating lease.
For finance leases, lessors recognise a financial asset equal to the net investment in the lease (stopping with the depreciation of the asset), while operating leases still involve recognising lease income over the lease term (with no impact on the asset depreciation).
IFRS 16 introduces new disclosure requirements for lessors to enhance transparency. These include details about how the lessor manages its risk associated with residual values of leased assets and a maturity analysis of lease payments receivable. This additional information helps users of financial statements better understand the lessor’s leasing activities.
4. Lease liability initial & subsequent measurement
Initial Measurement: A lease liability is initially measured at the present value of future lease payments (for further reading on lease liabilities please refer to lease liability (definition & calculation section).
This comprises of the following:
- fixed payments
- variable lease payments that depend on an index
- amounts expected to be payable under residual value guarantees
- and the exercise price of a purchase option (if it’s certain to be exercised)
The discount rate used is the interest rate implicit in the lease, or if that cannot be readily determined, the lessee’s incremental borrowing rate.
Subsequent Measurement: A lease liability is measured over time by accounting for the interest expense (increase) and lease payments made (decrease) to determine the closing balance.
Please refer to Exploring The Different Ways To Calculate Your Lease Liability
5. Right of use asset recognition & subsequent measurement
A right-of-use asset represents the lessee’s right to control the use of an asset for the lease term and ultimately the lessee recognises assets the balance sheet on the commencement of the lease.
Initial Measurement is the sum of:
- Present value of the lease liability
- Lease payments paid before the commencement date
- Initial direct costs incurred by the lessee (e.g. legal fees or commissions)
- Reduced by an lease incentives received
According to IFRS 16, subsequent measurement of the right-of-use asset is usually the cost model, but a fair value or revaluation model is also allowed in certain circumstances.
The cost model measures the asset:
- at cost plus any lease liability remeasurements
- less any accumulated depreciation and impairment losses
Any lease modifications, reassessments, or changes in either the lease term, index or rate used for payments may be subject to subsequent adjustment.
For deeper insights, refer to the right of use asset subsequent measurement section (IFRS 16 guide).
6. Expanded presentation & disclosure requirements
IFRS 16 increases the requirements for more transparency in lease accounting. It requires disclosures that are intended to enable users to understand the nature of an entity’s leasing activities.
Under IFRS 16, entities shall disclose:
- What’s Included? Companies need to share details about their leases, including the types of leases they have, key terms and conditions, and any restrictions or obligations tied to them.
- When Does It Matter? Businesses must disclose their lease commitments over time, breaking down future lease payments into different time periods. This helps in understanding how lease-related cash flows affect the company’s overall financial health.
- Why Does It Matter? Lease accounting impacts key financial statements—showing up as right-of-use assets and lease liabilities on the balance sheet, influencing expenses on the income statement, and shaping cash flow movements.
These disclosure requirements ensure that stakeholders can accurately assess the economic substance of leasing activities. They allow insight into operational flexibility by lessees, their financial leverage, and overall financial health. For annual reporting periods, these disclosures become very important because they help compare financial performance over time and against that of industry peers.
7. Subleases and sale and leaseback transactions
Under IFRS 16, a sublease is when one company is leasing and asset (lessee) and then also leasing it out to someone else (lessor). For their lessor lease, the company would classify the lease based on the criteria for finance or operating leases.
If the sublease is a finance lease, the company would derecognise the right-of-use asset from the head lease (lessee side), recognising a lease receivable with finance income over the lease term.
For an operating sublease, you would continue to recognise the right-of-use asset from the head lease with depreciation and recognising lease income over time.
For sale and leaseback transactions, the transfer of the asset should first constitutes a sale (IFRS 15). Then the seller-lessee measures the portion of the asset that was ‘retained’ as the right-of-use asset. The gain or loss on the sale is recognised only to the extent of the portion of the asset that was transferred to the buyer-lessor. This approach ensures that transactions involving leased assets are transparently reflected in the financial statements.
8. Remeasurement of lease liabilities
Lease liabilities are remeasured when specific events occur:
- Changes in the lease term: Contract amendments or exercising of extension options will affect a lease term.
- Changes in lease payments: Adjustments will be made due to the changes in variable lease payments linked to an index, or because of reassessment of purchase options.
When there is a remeasurement of lease liabilities under IFRS 16, adjust the lease liability and corresponding right-of-use asset. First recalculate the liability using revised discount rate if applicable, then adjust the right of use asset to match the remeasured liability. If this adjustment exceeds the asset carrying amount, the excess is recognised in profit or loss.
For a more detailed guidance, please refer to our modifications & remeasurements guide section.
9. Short-term & Low-value assets
Short-term leases are those that last 12 months or less. Low-value leases, on the other hand, apply to assets that typically cost less than USD 5,000 when brand new. Lessees can choose not to recognise these leases on their balance sheets but instead account for them essentially as an ‘operating’ lease by recognising the lease payments as expenses on straight-line basis over a lease term.
This is allowed, because a low-value lease would not have a significant impact on the financial statements and a short-term lease would have an insignificant financing component.
Impact on Financial statements:
- Balance sheet: Lessees avoid recognising right-of-use assets and lease liabilities, which keeps the balance sheet simpler.
- Income Statement: The expense recognised remains consistent with pre IFRS 16 accounting.
- Cash Flow statement: Cash outflows for these leases are classified under operating activities, consistent with past practices, rather than being split between operating an financial activities under the full IFRS 16 model.
The exemptions simplify the accounting processes. For more detailed guidance see short-term & low value assets section
10. Impact on financial ratios & statements
The adoption of IFRS 16 significantly transforms the lessee’s financial statements. By recognising right-of-use assets and corresponding lease liabilities for most leases, on the balance sheet which were often off-balance-sheet under IAS 17.
This change leads to an increase in both assets and liabilities, directly impacting the key financial ratios. Considering that the asset is a non-current asset, but the lease liability will affect the current and non-current liability section of the balance sheet.
The debt-to-equity ratio might increase due to the new lease liabilities, potentially altering stakeholder perceptions regarding a company’s leverage. Similarly, the asset turnover ratio would decrease as the asset base grows with the addition of right-of-use assets.
Moreover, this standard affects the cash flow statement by moving lease payments from operating to financing activities, and disclosing interest separately, rather than part of the cash flow from operations.
Lessees must carefully assess how these changes influence their financial performance, particularly for annual periods beginning after adopting IFRS 16. It’s crucial for companies to communicate these shifts effectively to stakeholders to maintain transparency and manage expectations regarding lease transfers ownership and the use of identified assets.
Final thoughts on our IFRS 16 Summary
IFRS 16 has reshaped lease accounting by making most leases appear on the balance sheet. This shift not only alters key financial metrics and ratios but also creates a deeper understanding among businesses to leverage this information for decision-making. Visibility of leases influences everything including investment decisions, making it essential for companies to fully grasp these leases activities.
Continued education on IFRS 16 is vital, and it is recommend that you stay updated through resources like our IFRS 16 guide, explore considerations for IFRS 16 software and consider training to manage these requirements. Adapting to regulatory updates will not only ensure compliance but also enhance financial planning.
Contact us to see how Rubli’s lease accounting solution and insights can help you navigate the complexities of IFRS 16 leases effectively.
